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Working Paper Working Paper Latin American Experiments in Central Banking at the Onset of the Great Depression FLORES ZENDEJAS, Juan, NODARI, Gianandrea Abstract This chapter analyzes the role of central banks during the first years of the Great Depression. The literature has focused on central banks' loss of autonomy and on the implementation of innovative, countercyclical monetary policies which fostered economic recovery but also led to higher rates of inflation and exchange rate volatility. However, we show that these kinds of policies had been foreseen by foreign advisors before and during the crisis. Policymakers had been reluctant to implement them due to the fear of a loss of credibility for the gold standard regime. Furthermore, we show that in most cases this shift was short-lived and central banks could avert, to a large extent, the problem of fiscal dominance. Central banks became effective actors, channeling credit to the real economy and also supporting the emergence of state institutions that would promote the development of local industry. Reference FLORES ZENDEJAS, Juan, NODARI, Gianandrea. Latin American Experiments in Central Banking at the Onset of the Great Depression. Geneva : Paul Bairoch Institute of Economic History, 2021, 32 p. Available at: http://archive-ouverte.unige.ch/unige:152742 Disclaimer: layout of this document may differ from the published version. 1 / 1 FACULTÉ DES SCIENCES DE LA SOCIÉTÉ Paul Bairoch Institute of Economic History Economic History Working Papers | No. 4/2021 Latin American Experiments in Central Banking at the Onset of the Great Depression Juan Flores Zendejas Gianandrea Nodari Paul Bairoch Institute of Economic History, University of Geneva, UniMail, bd du Pont-d'Arve 40, CH- 1211 Genève 4. T: +41 22 379 81 92. Fax: +41 22 379 81 93 Latin American Experiments in Central Banking at the Onset of the Great Depression Juan Flores Zendejas Gianandrea Nodari1 This draft: 22 June 2021 Abstract This chapter analyzes the role of central banks during the first years of the Great Depression. The literature has focused on central banks' loss of autonomy and on the implementation of innovative, countercyclical monetary policies which fostered economic recovery but also led to higher rates of inflation and exchange rate volatility. However, we show that these kinds of policies had been foreseen by foreign advisors before and during the crisis. Policymakers had been reluctant to implement them due to the fear of a loss of credibility for the gold standard regime. Furthermore, we show that in most cases this shift was short-lived and central banks could avert, to a large extent, the problem of fiscal dominance. Central banks became effective actors, channeling credit to the real economy and also supporting the emergence of state institutions that would promote the development of local industry. Keywords: central banking, Great Depression, gold standard, money doctors, financial crises Codes JEL: N0, N26, N160, F38 1 Juan Flores Zendejas is Associate Professor, Paul Bairoch Institute of Economic History at the University of Geneva and Professor by courtesy, Centro de Investigación y Docencia Economicas, CIDE. Gianandrea Nodari is Research Fellow at the Paul Bairoch Institute. The authors are grateful for the comments from the editors on a first version of this chapter. They acknowledge the financial support from the Swiss National Science Foundation, grant nr. 100011_192214. 1 Introduction In periods of economic downturns, one major problem that affects currency stability is fiscal dominance. This term refers to the situation in which an expansionary fiscal policy constrains the implementation of monetary policy (Sargent and Wallace 1981). Fiscal dominance might emerge mainly in the context of high levels of public debt, as central banks must support governments' efforts to reduce servicing costs. Latin America has traditionally been treated as a region in which fiscal dominance has reoccurred during periods of populist governments since at least the 1980s. (Edwards 2019). These episodes are characterized by expansionary fiscal policies aimed at financing large public investment projects and increased social transfers, while central banks pursued accommodative monetary policies that generally resulted in debt defaults and large increases in inflation rates. This chapter revisits the early years of Latin American central banks. In view of the changing economic and political conditions, we analyze how central banks made use of the monetary policy tools at their disposal in the aftermath of the Great Depression. Our narrative begins with a description of the motives underlying the creation of the first central banks in Latin America during the 1920s. In a nutshell, these new institutions were largely founded to solve the persistent problem of monetary instability, a condition that had led to conflicts among socioeconomic groups either benefiting or losing from exchange depreciation. The establishment of central banks was followed by the adoption of a gold standard regime and, in many cases, monetary reforms were also accompanied by a set of banking and fiscal reforms, generally designed by foreign advisors or “money doctors”.2 Governments expected central banks to provide monetary stability, to become a secure source of financing, to foster the capacity of the banking sector to provide credit to the private sector through rediscount operations, and to act as lenders of last resort. In this chapter we show that while the Great Depression led to the deterioration of central bank independence, it also triggered a set of institutional reforms designed to expand the kinds of instruments needed to conduct the region's monetary policies. The onset of the crisis had severely affected Latin America's economies, causing a sharp decline in the fiscal position of most governments. In many cases, governments decided to abandon the gold standard, to impose exchange controls and, ultimately, to default on their external debt. Central banks entered into expansionary monetary policies partly as a response to governments' financial needs, but also to support economic activity through the provision of credit. 2(Drake 1994; B. Eichengreen 1994; Flores Zendejas 2021). 2 The literature on Latin America's central banking in the interwar period has mainly focused on the role of foreign advisors in supporting the efforts by Latin American governments to adopt the gold standard. To a large extent, scholars have analyzed these relationships through the lens of US colonialism, first in central America at the turn of the 20th century, and then in South America, when Princeton Professor Edwin Kemmerer visited the Andean countries and designed the central banks established during the 1920s (Seidel 1972; Rosenberg and Rosenberg 1987; Drake 1994; Rosenberg 1999). Other works have looked at the missions lead by Otto Niemeyer, from the Bank of England, who advised Brazil and Argentina during the 1930s (Sayers 1976; Fritsch 1988; Sember 2018). The consensus of this literature is that the Great Depression marked a turning point in terms of economic policy. In the 1930s, money doctors largely lost relevance, partly because they did not tailor their advice to the new conditions of Latin American countries.3 A general consensus is that governments seized their countries' monetary institutions, leading to a permanent situation of high inflation and exchange instability.4 Nevertheless, this traditional narrative oversimplifies the characterization of the monetary policies implemented by Latin American central banks at the beginning of the 1930s and underestimates the role of money doctors during those years. While economic historians have emphasized the emergence of a new development model based on state-led industrialization, the role of central banks in that transition remains obscure and has been largely overlooked.5 Conventional views underline how, on the eve of the Great Depression, national monetary authorities promoted a set of unspecified countercyclical policies which fostered central banks discretionary powers.6 However, several questions regarding the temporality and the reasons behind central banks' participation in the transition to this new development model remain unanswered. Furthermore, we do not know which were the "countercyclical economic policies" and whether they were truly innovative. In this paper, we posit that Edwin Kemmerer had favored some of these countercyclical policies, yet local policymakers opposed them due to the fear of jeopardizing the credibility of the monetary regime. To some extent, the history of Latin American central banks in the 1930s is no different from that of central banks in other regions in terms of loss of autonomy.7 However, in many cases, after the first phase of currency devaluations, Latin American central banks often 3 On a survey of this literature, see (Flores Zendejas 2021). 4 See (Jácome 2015). 5 On the economic history of Latin America during that period, see (Bértola and Ocampo 2013; Victor Bulmer-Thomas 2003; Thorp 1984). 6 See (Pérez Caldentey and Vernengo 2020). 7 During the 1930s, a great number of central banks all over the world acted as government agencies in charge of exchange rate management, the implementation of clearing agreements and commercial banks' supervision. For an overview see (Toniolo 1988). 3 managed to maintain exchange rate targeting while also financing the new development model which would prioritize the support of the industrial sector. As we demonstrate,
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